How to Mitigate Casualty Liability Risk in Aviation Finance

Aircraft are considered a dangerous instrumentality, and aircraft incidents leading to the occurrence of an event involving the damage or destruction of such aircraft and/or related personal injury, death or property damage (a "casualty event") may involve potential and substantial liability to the owner, lessor, lender (secured party) and/or operator. Federal law generally protects lessors, passive owners and secured parties (collectively, "protected parties," or each a "protected party") from liability if such party is not in actual possession or control of the aircraft at the time of a casualty event. However, there are limitations in relying on federal law protections as state law interpretations of the meaning and effect of federal law differ.

The Transportation Code

Under 49 U.S.C. § 44112 (the "Transportation Code") (applicable to both private and commercial aircraft), protected parties are provided federal "preemption" protection from liability related to a casualty event if such protected party is not "in the actual possession or control" of the aircraft. Specifically, the Transportation Code provides that a lessor, owner or secured party (i.e., lender) is liable for personal injury, death or property loss or damage on land or water only when a civil aircraft, aircraft engine, or propeller is in the actual possession or control of the lessor, owner or secured party, and the personal injury, death or property loss or damage occurs because of (1) the aircraft, engine or propeller; or (2) the flight of, or an object falling from, the aircraft, engine or propeller." (emphasis added)¹ Under the Transportation Code, (a) "lessor" means a person leasing for at least 30 days a civil aircraft, aircraft engine or propeller; (b) "owner" means a person that owns a civil aircraft, aircraft engine or propeller; and (c) "secured party" means a person having a security interest in, or security title to, a civil aircraft, aircraft engine or propeller under a conditional sales contract, equipment trust contract, chattel or corporate mortgage or similar instrument.²

A major goal of the Transportation Code is to facilitate financing of the purchase of aircraft by protecting parties not in possession or control of the aircraft from liability for damages. The Transportation Code reflects the belief that liability should not apply to an entity that merely finances a lessee's acquisition or operation of aircraft.

Jurisdiction

Following a casualty event, a complex determination is made about which state jurisdiction's law to apply. Such determination may consider, among other things, the jurisdiction in which the casualty event occurred, the jurisdiction in which the aircraft is registered or the jurisdiction in which the lessor, owner or secured party is organized.

State Law

Applicable state laws vary and may be based on the bailment doctrine (holding a protected party liable if the aircraft was defective at the time it was supplied to the lessee or imputing the operational negligence of the lessee on the passive owner or lessor); negligent entrustment (holding the passive owner or lessor liable if it entrusts the aircraft to someone not competent or qualified to operate the aircraft); negligent supervision (holding a protected party liable when the lessor unreasonably allowed the lessee to retain possession of the aircraft during the term of the lease when the lessee's qualifications or competence were deteriorating); or vicarious liability, including strict liability and breach of warranty (holding a protected party liable, notwithstanding lack of fault, for any damage on or caused by the aircraft).

Effect of Federal Preemption

Under the concept of federal preemption, most courts have held that the effect of the Transportation Code is that protected parties are not responsible for any injuries or damages under state law if they are not in control or possession of the aircraft at the time of the casualty event.³ However, protected parties need to be cognizant that some state courts have narrowly interpreted the Transportation Code to not preempt more stringent state liability laws.⁴ It should be noted that aviation finance commentators have criticized such cases as not properly interpreting the Transportation Code.

Foreign Law

Foreign laws vary, but generally liability laws fall into three categories: (1) no liability except in the case of fault by the owner/lessor; (2) liability if the owner/lessor is in effective control of the aircraft; and (3) strict liability of owner/lessor.

International Conventions

Certain international conventions, particularly the 1952 Rome Convention⁵ (the "Rome Convention") address liability of lessors, owners and secured parties on a global basis. However, none, including the Rome Convention, are fully implemented, and therefore, do not provide any meaningful comfort to lessors, owners or secured parties. These conventions are beyond the scope of this article and will not be discussed.

Mitigation Steps

Insurance

Insurance is the principal means of mitigating the risks that lessors, owners and secured parties face with respect to third-party liability relating to a casualty event. Main provisions of aviation insurance include hull insurance and liability insurance, each provided by the lessee/operator, and contingent or umbrella insurance coverage, which is obtained by a lessor or secured party to supplement the insurance obtained by the lessee/operator. Hull insurance covers loss of, or damage to, the aircraft and is based on the replacement cost or fair market value of the aircraft; the lessor, owner or secured party (as applicable) should be named as the loss payee. Liability insurance covers third-party liability arising from casualty events relating to the use, maintenance and operation of the aircraft and should name the lessor, owner and/or secured party (as applicable) as additional insureds. Insurance market minimum liability policies are between $500-750 million for narrowbody aircraft and $1 billion for widebody aircraft. Insurance provisions should be specified in an aircraft lease or loan agreement and certification of insurance should be provided for review to verify coverage.

Breach of warranty coverage is also important as it covers the lessor, owner or secured party (as applicable) even if a casualty event is caused by the lessee/operator's negligent practice or as a result of any breach of warranties by lessee/operator, which would invalidate insurance as to such lessee/operator. However, an insurer may deny liability coverage to an additional insured if such additional insured's own negligence caused or contributed to the casualty event. For example, an insurer could refuse to pay under a policy by alleging that the lessor or secured party was negligent because such party: 1) failed to exercise the rights available to it under the lease or loan documentation to monitor compliance by the lessee/operator with its maintenance or operational covenants, or 2) had actual knowledge that the lessee/operator failed to comply with its maintenance or operational covenants and permitted such failures by not exercising appropriate remedies against the lessee/operator. In either case, such negligence caused or contributed to the casualty event. It is important for protected parties to exercise their rights of inspection and monitoring of lessee/operator and to promptly take enforcement actions (including grounding of aircraft) permitted by the loan or lease documentation in the event of any default or violation of lessee/operator's obligations with respect to their possession, use, operation and maintenance of the aircraft.

Ownership Structure

Special purpose vehicles ("SPVs"), which may include the use of limited liability companies and owner trusts, may be used to provide a separate legal level of liability protection and as a means to isolate or limit lessor liability. When using SPVs, a protected party should maintain corporate formalities so as to not enable an argument for "piercing the corporate veil" and should adhereto regulatory and insurance requirements. Note that use of an owner trust is not an assured means for a protected party to avoid liability. Some courts have sought to impose personal liability on beneficial owners of owner trusts by applying a "control test" that focuses on the extent of the beneficial owners' control over the conduct of the affairs of the trust. Some trust statutes reject the control test and provide certainty by stating that, except to the extent otherwise provided in the governing instrument of the trust, the beneficial owners shall be entitled to the same limitation of personal liability extended to stockholders of corporations. These statutes permit the beneficial owners to participate in the management of the trust, including directing the trustees, without assuming personal liability for the obligations of the trust.

Of importance to owners of private aircraft, setting up an SPV such as an LLC, without more substance (i.e., independent income or business), may cause a violation of FAA regulations (Part 91 or Part 135) because the owner is the sole member of the SPV providing funds to pay for aircraft expenses and use. Part 91 provides that an owner cannot receive compensation for use of aircraft (other than in the case of limited exceptions). If an FAA regulation is violated, there is risk of invalidating applicable insurance policies and a third party may argue for piercing the corporate veil. Entering into a third-party management agreement may offer protection from potentially violating FAA regulations as another entity would be responsible for managing the aircraft.

Representations, Warranties and Covenants

The lease or loan documentation should include a "hell or high water" clause, which requires the lessee/operator to continue making payments regardless of encountering difficulties with the aircraft, and a triple net lease provision, which requires the lessee/operator to maintain required insurance and be responsible for all use, operation and maintenance of the aircraft.

The documentation should also provide that the aircraft is delivered "as-is, where-is" and with all faults, and disclaim any representations, warranties or other guaranties as allowed by law. It should also contain the standard disclaimer by lessors and secured parties of all representations and warranties relating to the aircraft other than as specifically given (such as title). Other important covenants include indemnification clauses and requirements and restrictions on use of the aircraft.

Event of default provisions should, in addition to standard payment or credit defaults, provide for breach of use, maintenance, operation and return conditions as a means to exercise enforcement actions for default by lessee/operator. Note, however, that there are issues to consider if the lessor and/or secured party exercise remedies, such as in the case of repossession, where there is a greater risk of being considered to have operational control and therefore lose protection from liability under the Transportation Code. A protected party should try to avoid operational control over the aircraft or the lessee/operator beyond default remedies. In the case of foreclosure, where a lessor or secured party becomes the owner or lessor of an aircraft, such party could have higher liability risks under state law because such party would be exerting more control over the aircraft and (possibly) the related of lessee/operator. Risk can be minimized if the lessor or secured party grounds the aircraft (except for any necessary ferrying of the aircraft to a maintenance or storage facility).

Lessors and secured parties can avoid certain liability issues relating to the aircraft entirely by conducting a foreclosure sale to a third party as an exercise of remedies, which would preclude such lessor or secured party from becoming the owner of the aircraft at any point in time. In an aircraft finance transaction involving multiple aircraft, the credit and security documents will typically allow the lender to conduct foreclosure sales with regard to different aircraft at different times, with or without possession.

Use of Servicers and Remarketing Agents

Protected parties can retain servicers or remarketing agents to assist in monitoring airline or operator compliance by monitoring aircraft maintenance and other covenants, repossession of aircraft, maintaining and insuring aircraft acquired through foreclosure sale, and remarketing and operating aircraft. Retaining servicers and remarketing agents helps to ensure that aircraft safety and maintenance are overseen and operated by persons with significant relevant experience. It also minimizes the risk of the Protected Party being denied insurance coverage and being found liable for negligence in states that may not recognize the preemption of their laws by the Transportation Code or foreign jurisdictions that do not have laws similar to the Transportation Code.

In conclusion, financing aircraft does not come without risk, but such risk can be mitigated if protected parties are mindful of various compliance procedures afforded by the requirement of the Transportation Code and observance and strict requirements of the mitigation and protection procedures described above.